Transcript
Amada Agati:
In this edition of "Adding Alpha," we highlight what's at the top of our Christmas wish list for Santa. Spoiler alert -- it's a Fed pause that will be the key to forward progress for the markets
and the economy in 2023.
This has become an annual tradition for us, challenging ourselves to determine what could be the single most important catalyst to drive markets higher in the new year and putting that at the top of our wish list.
The Fed remains in the driver's seat in 2023, just as it has been for all of 2022. Longer for longer appears to be the name of the game for the Fed's monetary policy strategy in this game of the market trying to call the Fed's bluff. More rate hikes, a higher terminal rate, and a longer overall tightening cycle.
Since so much of last year was dependent on Fed rate hikes, the market has already priced in the following path for this year -- 25 basis points in February and another 25 basis points in March. But what's going to happen after that? Powell basically told markets, don't expect any rate cuts, and yet the market has already priced in at least 50 basis points worth of cuts beginning in the second half of 2023.
It's a frosty reminder that the Fed and the markets have not been on the same page since the Fed's policy pivot at the start of last year, and that the Fed's dual mandate of maximum employment
and price stability does not consider supporting the stock market.
So it feels a bit more like Groundhog Day, as this is eerily reminiscent of 2018, when the Fed was effectively hiking interest rates on autopilot.
Needless to say, our wish did not arrive in time to be gift wrapped under the tree that year. But sure enough, it eventually arrived in early January of 2019 as Fed Chair Powell finally indicated a pause would be forthcoming.
Markets recovered and the S&P 500 went on to generate really strong returns that year. We believe what matters most for markets right now is getting a line of sight to the end state for monetary policy.
The terminal rate and the Fed's revised dot plot is now 5.1%, and 5.1% will be deep into restrictive territory for markets, the economy, and financial conditions, making the odds of a hard landing in 2023 pretty high.
PNC Economics believes a recession may occur beginning in Q2 and lasting through Q4 of 2023. There's never been a scenario where the Fed hiked rates to 5.1% or higher and avoided an economic contraction. However, Fed policy is still very much data-dependent, which means a recession is not a foregone conclusion.
With earnings multiples hovering around historical averages and consensus earnings estimates still calling for positive earnings growth in 2023, we are not priced at recessionary valuation levels,
which could, in our view, translate to another 10% to 15% downside for equities.
Based on what the Fed said in December, we believe investors should be prepared for more market downside this year. The good news is that we expect this downside to be somewhat short-lived. With the Fed remaining firmly in the driver's seat, we expect the market to continue to anticipate and quickly price in all of the Fed's tightening moves.
However, as we begin to see a sustained decrease in inflation and the Fed slows or even pauses rate hikes, we expect valuation multiples to bounce back.
From our perspective, a Fed pause is almost the same as a cut in the market's view. So if long term interest rates do indeed begin to decline, we believe that backdrop could equate to 2 to 3 multiple points of valuation, multiple expansion later in the year, all else equal.
